TALF Creates a New Class of Toxic CMBS Assets

The unintended consequences of the TALF and quantitative easing are glaring in the CMBS credit default swap markets. Both the TALF and the Federal Reserves purchases of assets were conceived to thaw the securitization markets by purchasing AAA rated securities. However, since there is no other market than the one made by the government, a huge gap between AAA and lower rated tranches has emerged.

The net result is any security rated below AAA is now de facto “toxic”. The charts below are from Markit and illustrate the spreads on the CMBX indices. The CMBX index is an index of credit default swaps on CMBS (Commercial Mortgage Backed Securities).

Click to enlarge:

The AAA CMBX Index has fallen since the TALF announcement, while the BBB has remained at all time highs. The risk spread between the two tranches has never been higher. While the Federal Reserve and Treasury have had the best of intentions what they have actually done is create a whole new batch of toxic assets.

Disclosures: None

Comments

[Moon Kil Woong:]

Hmmm, keen insight.

A s the government moves into corporate bonds and credit card debt expect the same disparity between what the government will support/back/guarantee/or take onto its books and what it won't. Unintentionally, what it won't take on it's own books may suddenly become junk even though it was just high yielding before.

Mar 31 05:02 AM

[MichaelJ007:]

Wasn't it toxic junk before the GOV stepped in? If there is any increased dealflow in any tranche it'd be an improvement.

Mar 31 08:21 AM

[Brian Kelly:]

I also think that the T-bill auctions will be a key to watch. Since the Fed is only buying 2-30 yr maturities the same disparity could occur if investors only want what the government is buying. I am not suggesting that T-bills are junk or toxic, just that it may take a little extra yield to entice buyers.


On Mar 31 05:02 AM Moon Kil Woong wrote:

> Hmmm, keen insight.
>
> A s the government moves into corporate bonds and credit card debt
> expect the same disparity between what the government will support/back/guarantee/or
> take onto its books and what it won't. Unintentionally, what it won't
> take on it's own books may suddenly become junk even though it was
> just high yielding before.

Mar 31 08:45 AM

[convexity:]

The fact you cite doesn't support your thesis at all.
1. Though the move in CMBX5 BBB- from January to March in spread is substantial, the dollar price move is actually quite small (due to convexity). Further, the BBB part of the capital structure is miniscule compared with the overwhelming amount AAAs outstanding. Therefore, the overall value of all outstanding CMBS rallied since the TALF announcement.
2. The Markit data actually shows that the BBB- index was basically unchanged over the TALF announcement date. How does that show that TALF destroyed value in those tranches?
3. Much more importantly, the government didn't cause this. Poor lending standards, overpriced CRE, etc mean that the junior and mezz investors stand almost no chance of receiving their principal. I can't think of any government intervention that could halt this. That is, the value destruction in junior tranches in CMBS (as well as RMBS and other asset classes such as CLOs) is fundamentally driven and thus not curable by liquidity injection.

(It's also worth pointing out that, due to the way that CMBX yields are calculated as well as the very low liquidity in the index and the underlying individual tranches, spread changes in the CMBX may or may not actually be an accurate measure of value or change in value.)

Mar 31 08:55 AM

[Analyst Mayank:]

An interesting thing to watch will be rating transitions from "not so AAA" to "so called AAA". In a system over dependent on rating agencies it wont be too difficult for a lower rated tranche to be converted into a AAA by posting additional collateral (toxic?).

Mar 31 09:34 AM

[Fishooks:]

I'd take your observation and argue the opposite position. Whether or not you agree with re-instituting leverage into the system through the legacy-TALF (albeit without the pesky margin calls that banks used to enforce), the initial reaction displays the marketplace's view of the difference between liquidity-strained and toxic.
BBB rated tranches with ~5% credit enhancement were and are fundamentally troubled given the poor underwriting characteristics in combination with declining real estate values (as 'Convexity' points out). Having more $$$ in the system doesn't change the opinion cashflow/terminal principal value.
Even though the tightening in AAA assets since PPIP/Legacy TALF were announced is nowhere near enough to signal a turn in fortune, it does display that the market's price point at this part of the capital structure (30% attachment point) is significantly impacted by the availability of $$$ (or at least the perception of the availability of $$$) to own the securities. Thus, it could be appropriately argued that it's more of a technical trading issue than a toxic asset issue. By that logic, at least 70% of the CMBS universe on a notional basis (much more on a market value basis, no matter what you perceive market value to be) is in the midst of a technical issue not a fundamentally toxic one.

Mar 31 12:02 PM

[Brian Kelly:]

Fishhooks,

As I understand your position, it is similar to the logic the government is using, i.e., the perception that money is available to fund AAA asset purchases has tightened that space and that action should lead to other tranches tightening as well.

In that light, it is a technical issue as opposed to a toxic issue, which is exactly the bank's logic behind not marking down assets. They claim a liquidity constrained market is not a market. But I think we are really talking semantics--if I can't sell an asset when I want/need to it is toxic to me.


On Mar 31 12:02 PM Fishooks wrote:

> I'd take your observation and argue the opposite position. Whether
> or not you agree with re-instituting leverage into the system through
> the legacy-TALF (albeit without the pesky margin calls that banks
> used to enforce), the initial reaction displays the marketplace's
> view of the difference between liquidity-strained and toxic.
> BBB rated tranches with ~5% credit enhancement were and are fundamentally
> troubled given the poor underwriting characteristics in combination
> with declining real estate values (as 'Convexity' points out). Having
> more $$$ in the system doesn't change the opinion cashflow/terminal
> principal value.
> Even though the tightening in AAA assets since PPIP/Legacy TALF were
> announced is nowhere near enough to signal a turn in fortune, it
> does display that the market's price point at this part of the capital
> structure (30% attachment point) is significantly impacted by the
> availability of $$$ (or at least the perception of the availability
> of $$$) to own the securities. Thus, it could be appropriately argued
> that it's more of a technical trading issue than a toxic asset issue.
> By that logic, at least 70% of the CMBS universe on a notional basis
> (much more on a market value basis, no matter what you perceive market
> value to be) is in the midst of a technical issue not a fundamentally
> toxic one.

Mar 31 12:32 PM

[CJJ:]

The real issue is they packaged 30 year to maturity assets into vehicles that need to be marked after just months-years of being packaged. This really doesn't work well when the economy tanks.

Again people don't realize there was a five year "mess up" and people aren't looking to address this. Someone writing a story would just erase it. Someone playing a video game would just start the level over.
We're all trying to continue along without just taking care of the mistake.

Mar 31 10:52 PM